Valuation-Informed Indexing #189
by Rob Bennett
It’s not hard to understand why most investors view stock gains as a good thing. There’s an announcement on the radio that stock prices have increased by 12 percent over the past year. It shows in your portfolio statement. You understand that, if you wanted to cash in your portfolio, you would get more cash for doing so than you would have gotten for doing so a year earlier. Stock gains make you rich. Stock gains are a good thing.
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Except they’re not.
Not if you believe in the “revolutionary” (his word) 1981 research of Yale Economics Professor and Nobel Prize Winner Robert Shiller showing that valuations affect long-term returns and the 33 years of peer-reviewed academic research published since that confirms Shiller’s findings. If that research is on the mark, stock gains are a bad thing.
Say that stocks are priced at two times fair value. Shiller’s research shows that high prices cause crashes. A price increase that makes an overvalued market even more overvalued makes the crash even bigger and increases the chance that it will take place sooner. How is that a plus? This is a case where stock gains are a bad thing.
But it is not only when the market is insanely overpriced that stock gains become problematic. Say that stocks are priced at fair value. If you buy stocks when they are selling at that price, your most likely annualized 10-year return is 6.5 percent real. What happens if the price goes up? The likely return goes down. Price crashes don’t bring on crashes when stocks are priced at fair value. But they still have their downside.
And that downside is greater than the upside provided by the increase in your portfolio value.
Say that you’re 35 years old and that you expect to retire at age 65. You’ll be buying stocks for another 30 years. If stock prices increase this year, you’ll see an increase in your portfolio value. But you’ll also be forced to pay a higher price for the stocks you buy with each paycheck. Do the math and you’ll see that you would be better off if the price gain were delayed until closer to your retirement date.
Stocks are like anything else you buy. They offer a better value proposition when you pay less for them. And stock gains always push prices up. Since you are going to remain a net buyer of stocks for many years to come, stock gains are bad for you.
How about when the market is underpriced? There have been times (the last one was in 1982) when stocks were priced at one-half of fair value. Surely stock gains are a good thing in those circumstances.
A good case could be made that that is so. When prices are insanely low, the economy is in a recession (low stock prices lower the buying power of millions of investors, leaving them with less to spend on good and services and thereby putting hundreds of thousands of companies out of business). When prices are where they were in 1982, stock gains push prices in the direction of where they would be in a rational world and thereby help us out of an economic collapse. That’s obviously a good thing.
However, even in that circumstance, stock gains are not an entirely good thing.
The most likely 10-year annualized return when stocks are priced at one-half of fair value is 15 percent real. It is the big stock gains we always see once prices drop that low that are the cause of those outsized returns. Each stock gain pulls the future expected return down. Stock gains certainly make sense when prices are low. But they still come at a price and they still increase the price that all of us who are in the process of financing our retirements have to pay for buying the stocks we need to get the job done.
Stock gains are just not a good thing.
Why is it that we all are so inclined to think they are?
There obviously have to be some stock gains at some time for stocks to be worth buying. The real problem is of course not that stocks produce gains. We buy stocks to get the gains. The problem is that stocks are bought and sold and the gains cause us to pay higher prices for the stocks we buy. When you begin selling stocks to finance your retirement, you really do want to have as much in the way of gains in place as possible. For retirees who no longer buy stocks, gains are a pure good. But most of us are not in that position. So there is a negative associated with stock gains for most of us.
The other problem is that we don’t think clearly about the stock accumulation process. We all view increases in the prices of cars and bananas and computers as a bad thing. We view things differently when it comes to stocks because we think of ourselves as owners of stocks rather than buyers. It’s those portfolio statements. They tell us that we are owners and suggest that price increases should suit us fine.
However, for most of us the reality is that we are more buyers of stocks than sellers of them. So we should be rooting for low prices, not high prices We should be rooting for price drops, not price increases.
What if large numbers of us began rooting for price drops? That would be wonderful. There would be no more bull markets. Which means that there would be no more bear markets. Which means that there would be no more economic crises.
There would still be price gains because stock prices ultimately reflect economic realities and the real value of stocks increases enough each year to support a price gain of 6.5 percent real. But if we came to understand that price drops enrich most of us more than price gains, much of the craziness associated with stock investing would disappear.
Markets function best when there is a tug of war between the forces pushing prices upward and the forces pushing prices downward. The big problem we have today is that most stock investors know for certain something that just isn’t so — that price gains are a good thing.